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ETF Specialist

When Indexing Fails: Junk Bonds

Just because junk-bond ETFs trade well does not mean they track their asset class well.

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The popularity of indexing has become indiscriminate. Some asset classes are not amenable to indexing, and some exchange-traded funds should be avoided for that--especially junk-bond ETFs. These products fail on two levels: Their underlying asset class may be systematically overpriced, failing to offer returns commensurate with their risks, and their price-indifferent trading imposes enormous hidden costs on investors.

Illusory Returns, Real Risk
At first glance, the historical record contradicts me. Over the past 26 years, junk bonds, proxied by the BoAML U.S. High Yield Master II Index, have returned 8.8% annualized with an 8.6% standard deviation, for a 0.58 Sharpe ratio. Most investors would envy such a record. However, much of the return came from decades of declining interest rates, which provided a big capital appreciation boost. Junk bonds look less impressive against duration-matched Treasuries, outperforming by 200 basis points and with much higher volatility. Not bad, but much of the return advantage is illusory. To get a sense of how difficult it was to obtain the index's returns, look at junk-bond mutual funds. Of the 27 high-yield funds that have survived since 1986, the starting year of the high-yield index, not one earned a higher Sharpe ratio than the index, and only one posted higher absolute returns. These are the winners; the ones that died off posted much worse returns.

Samuel Lee does not own shares in any of the securities mentioned above. Find out about Morningstar’s editorial policies.

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